Memeorandum

September 22, 2008

Waiting For The Belly Laughs

In the course of evaluating the Dodd proposal I had predicted that, although it was nothing like Krugman's call for direct equity investments by the government to support the financial services sector, Krugman would support Dodd anyway. Why? Basically, because Sen. Dodd is a reliable progressive and anything proposed by Bush or his minions is evil and corrupt.

How do Krugman and Dodd differ? Here is Krugman from his column today:

...the financial system needs more capital. And if the
government is going to provide capital to financial firms, it should
get what people who provide capital are entitled to — a share in
ownership, so that all the gains if the rescue plan works don’t go to
the people who made the mess in the first place.

Let's move past my point that Paulson's plan address the asset-to-capital problem by allowing firms to reduce assets rather than obliging them to raise capital. Are the direct equity investments for which Krugman is calling anything like what Dodd is proposing? No. Dodd has a mysterious contingent make-whole provision designed to protect the taxpayer from losses, not to re-capitalize the financial services sector or enhance financial stability. It can be illustrated as follows (or see the bill text here):

1. The Treasury buys a troubled asset from a firm for some amount, say $10 billion.

2. *IF* the Treasury later decides to sell the asset and *IF* the Treasury takes a loss, the original seller is on the hook for 125% of the loss. Please note that this loss may simply reflect broad market movements and have nothing to do with whether the original purchase price was fair and transparent. Let's hypothetically assume the sale occurs for $8 billion, for a loss of $2 billion. 125% of $2 billion is $2.5 billion, which is now owed by the seller to the Treasury.

3. To make good on the loss, the seller issues new shares to the Treasury. The key wrinkle - the new shares are valued at the average market price at the time of the original sale, not at the market price when the Treasury realized a loss. So if the seller has become distressed in the meantime and its share price has fallen from $25 per share to $2.5 per share, it will issue 100 million shares shares ($2.5 billion / $25) to the government worth only $250 million. On the other hand, if the seller's shares have appreciated to $50, it will still issue 100 million shares but their value to the Treasury will be $5 billion.

Now, is that anything like the direct equity investments that Krugman advocated? Of course not. First, the Treasury may never formally book losses - if it simply plays a buy and hold strategy with its acquired assets it will never book losses, although it may lose hundreds of billions on a cash flow basis.

Secondly, new capital is not really being provided by the government. Instead, in the above example the government in effect pays $10 billion for the troubled asset. In the fullness of time, and if the asset has both depreciated and been sold, the government in effect revises the original deal - the revised deal is the same as if the firm had presciently sold the assets for $8 billion *and* issued 100 million shares to the government at a discounted price of $2 billion.

Both before and after the revision the firm receives $10 billion from the government, so the revision does not represent new capital. However, although the asset was "sold" the seller was still at risk for future losses and equity holders were at risk of dilution. Hence, the "sale" did little to reassure equity holders or make the firm more able to attract new equity investment. However, as with the Paulson plan, the seller did improve its asset-to-capital ratio by shedding $10 billion in assets.

So - since the Dodd plan does not put new capital into financial services firm on any predictable basis and is almost surely less stabilizing than the Paulson plan, Krugman will oppose it, right? Of course not. Krugman now claims he has had a chance to evaluate the Dodd proposal and (surprise!) he likes it. Well, there are some oversight modifications that Krugman ought to like (I do), but mainly he misconstrues the Dodd plan in order to endorse it. Here we go:

I’ve had more time to read the Dodd proposal
— and it is a big improvement over the Paulson plan. The key feature, I
believe, is the equity participation: if Treasury buys assets, it gets
warrants that can be converted into equity if the price of the
purchased assets falls. This both guarantees against a pure bailout of
the financial firms, and opens the door to a real infusion of capital,
if that becomes necessary — and I think it will.

The Wall Street Journal used the "warrant" metaphor, so maybe he got it from them; that word is not used in the text of the bill to describe this equity scheme. At some point, one hopes Krugman actually reads the bill. Let me copy the key provisions below:

(1) IN GENERAL.—The Secretary may not purchase, or make any commitment
to purchase, any troubled asset unless the Secretary receives
contingent shares in the financial institution from which such assets
are to be purchased equal in value to the purchase price of the assets
to be purchased.

...(3) VESTING OF SHARES.—If, after the purchase of troubled assets from a
financial institution, the amount the Secretary receives in disposing
of such assets is less than the amount that the Secretary paid for such
assets, the contingent shares received by the Secretary under paragraph
(1) shall automatically vest to the Secretary on behalf of the United
States Treasury in an amount equal to— (A) 125 percent of the dollar
amount of the difference between the amount that the Secretary paid for
the troubled assets and the disposition price of such assets; divided
by (B) the amount of the average share price of the financial
institution from which such assets were purchased during the 14
business days prior to the date of such purchase.

A note - in clause (1) the contingent shares are described as "equal in value to the purchase price of the assets
to be purchased". My guess is that this is to cover the scenario in which the final asset sale described in (3) occurs at a price of zero. If the actual sale price is higher, the value is reduced as per the 125% formula.

As I hope the example above made clear, this is nothing like a conventional equity or warrant sale; Krugman's notion that "This... opens the door to a real infusion of capital" is simply not based on the text of the bill.

Dodd's objective with this "equity" provision is to allow Treasury to recoup realized losses. It has nothing to do with, and in fact detracts from, ensuring financial stability or infusing capital into the financial system.

And why do I focus on Krugman's misconceptions? Sadly, he has a powerful platform and an influential voice. Here, for example, is TIME's Joe Klein, who is over his head here:

There seems to be a rare harmonic convergence on the op-ed page of the New York Times today, both Paul Krugman and William Kristol--the alpha and omega of the Times' columnist corps--are opposed to the Bush Administration gargantuan Wall Street bailout.

Krugman obviously knows a lot more about economics than Kristol.
Indeed, Krugman has been written early and often about the disastrous
potential of the housing bubble. And I would trust him here--the
taxpayers' stake in this bailout is best protected by the government
taking an equity stake in the affected firms...

A lot of the progressive blogs (the "progosphere") will follow Krugman's lead, given his academic and economic credentials. And this Treasury rescue plan is huge and problematic, so having sharp eyes look at it and sensible people debate it ought to be a good thing. Too bad Krugman is shirking his role as analyst and is simply cheerleading and misrepresenting the actual Dodd proposal.

NEXT: Any predictions on how or whether Krugman climbs down? He only has about a week.

HEADSCRATCHER: After a "sale" of their assets to the Treasury firms are still liable for losses (although they do not share in gains). Should firms be hedging this exposure? How? And put your hand up if you think this increases the stability of the firms. I don't see any hands...

IN THE NEWS: I have yet to find a media account that jibes with my analysis (or changes my mind), but this is interesting:

Massachusetts Democratic Rep. Barney Frank told reporters
that the administration has accepted some conditions laid down
by Democrats, including giving the government a stake in any
institution unloading assets under the plan. But sources close
to the Treasury said it was opposed to equity stakes and Frank
later said: "Apparently I was premature."

Just to plant my flag - I don't have a big problem with some sort of equity provision, as long as we know what we are trying to accomplish with it. If the goal is to add capital to the system, fine. If the goal it to increase investor uncertainty and randomly punish some firms (but not others) for asset price moves that may simply reflect market movements, I am less keen.

The industry is balking at proposals to allow the Treasury to acquire
ownership stakes in institutions that offload their toxic mortgage
assets onto the government and to impose caps on the amount such
companies pay their executives.

...

But on Monday key Democrats moved to heap their own proposals onto the
plan, seeking to protect taxpayers against losses and require the
government to do more to help strapped homeowners.

The Dodd priorities are described as helping homeowners and avoiding taxpayer losses, not adding capital to the system.

While details are still being worked out, both sides have also
agreed to a measure that would allow -- but not require -- the Treasury
to take an equity stake in a financial institution that sells assets to
the government. Whether it did so might be dependent on the size of the
capital injection the government makes when it buys the assets,
according to a person familiar with the matter.

There are precedents for the government taking stakes in private
companies, dating back to the bailout of Chrysler Corp. in 1979, when
the government got warrants to buy Chrysler shares. Most recently, the
Federal Reserve took warrants in American International Group Inc.,
representing a majority equity interest in the big insurer.

I’m just a simple cowboy, livin’ the dream and missing my sheep. But,
in my frequently kicked brain this looks a like Yellowstone did just
before the entire thing went en fuego. There was so much work put into
keeping a fire from starting, much less burning, that the underbrush
and the dead wood finally gave us a conflagration devoutly not to be
wished. At the end of the reign of that theory of forest management,
someone with a modicum of awareness of the implacability of nature
realized that lightening was not the enemy of the Park.

I'm reposting this on the advice of counsel (JM)from an earlier thread. I apologize for the length:

I have a general idea for avoiding future liquidity contagion problems with derivative securities, but I'm not sure it's practical. What I was thinking is that securities could have "crisis" or "system failure" clauses. These would be restrictions on how much lenders (in a broad sense) would be paid conditional on some market-wide, non-manipulable indicator of a crisis (spreads over Treasury, perhaps, or volumes of cash withdrawals from predesignated banks and mutual funds, or...?).

These clauses could be set up to give the lender an option--"If spreads over Treasury go over x points and you call your bond or ask for more collateral or whatever, you only get y% of the face value you are owed." (Perhaps this could be enhanced with an encouragement such as "If spreads go over x points and you DON'T withdraw your liquidity at the crucial moment then you get 1+z times your money when the crisis is past.") These haircut percentages could possibly be made nonlinear in the degree of crisis so that their deterrent effect was highest when the panic was greatest.

The idea is to create a counter-incentive to panic by penalizing withdrawals of liquidity that occur just when liquidity is most needed by the system. And if I see that everyone else is facing the same incentives, my own level of panic that everyone else is pulling their money out is reduced and a virtuous cycle is created.

Another way to look at it is that systemwide liquidity risk cannot truly be hedged or insured, yet current contracts (and valuation methods) don't account for this. Everyone getting their money out at the same time is always going to be impossible no matter how we regulate, as long as we have some version of borrowing short and lending long (and I kind of like modern civilization). If everyone agreed (or were required) to only do business with borrowers who included such "crisis-haircut" clauses in all their securities, perhaps liquidity contagions would be less likely and the system more robust.

I welcome any comments about whether this idea makes sense or how it could be implemented or if we already have such things but they somehow don't work. Note that any crisis indicator must be non-manipulable by an individual entity--otherwise they could use manipulation to avoid paying people whenever they felt like it, and no one would do business on that basis.

(a) IN GENERAL.—Not later than 7 days after the
11 date on which the Board exercises its authority under the
12 third paragraph of section 13 of the Federal Reserve Act
13 ((12 U.S.C. 343), relating to discounts for individuals,
14 partnerships, and corporations) the Board shall provide to
15 the Committee on Banking, Housing, and Urban Affairs
16 of the Senate and the Committee on Financial Services
17 of the House of Representatives a report which includes—
18 (1) the justification for exercising the authority;
19 and
20 (2) the specific terms of the actions of the
21 Board, including the size and duration of the lend22
ing, the value of any collateral held with respect to
23 such a loan, the recipient of warrants or any other
24 potential equity in exchange for the loan, and any
25 expected cost to the taxpayer for such exercise.

I need to ask you to support an urgent secret business relationship with a transfer of funds of great magnitude.

I am Ministry of the Treasury of the Republic of America. My country has had crisis that has caused the need for large transfer of funds of 800 billion dollars US. If you would assist me in this transfer, it would be most profitable to you.

I am working with Mr. Phil Gram, lobbyist for UBS, who will be my replacement as Ministry of the Treasury in January. As a Senator, you may know him as the leader of the American banking deregulation movement in the 1990s. This transactin is 100% safe.

This is a matter of great urgency. We need a blank check. We need the funds as quickly as possible. We cannot directly transfer these funds in the names of our close friends because we are constantly under surveillance. My family lawyer advised me that I should look for a reliable and trustworthy person who will act as a next of kin so the funds can be transferred.

Please reply with all of your bank account, IRA and college fund account numbers and those of your children and grandchildren to wallstreetbailout@treasury.gov so that we may transfer your commission for this transaction. After I receive that information, I will respond with detailed information about safeguards that will be used to protect the funds.

Who gets to value the contingent liability? Does it go down on the books at 100% of the value of the MSB sold or would a prudent investor demand that it be marked to 125%?

I'd kinda like to know so that I can make some calculations concerning potential dilution of ownership interest before I risk any money by purchasing shares.

Maybe someone will sell me some sort of an insurance policy protecting me from the contingent liability - maybe we could call it a credit default swap or something like that? There might even be a big market for such an instrument.

I wish someone would mock up a balance sheet for Senator Dodd and have him show us how this all works.

What I would like to see is the Fed buy the debt in exchange for equity shares now, with the Fed getting preferred dividends until the loan has been repaid. This would wipe the books in the short term, keep the firms responsible for the bad deals they had previously made, and encourage them to pay off the loan quickly. The stockholders would take it in the shorts, but if the firm is able to pay off the loan quickly then the pain will be brief.

I’m just a simple cowboy, livin’ the dream and missing my sheep. But, in my frequently kicked brain this looks a like Yellowstone did just before the entire thing went en fuego. There was so much work put into keeping a fire from starting, much less burning, that the underbrush and the dead wood finally gave us a conflagration devoutly not to be wished. At the end of the reign of that theory of forest management, someone with a modicum of awareness of the implacability of nature realized that lightening was not the enemy of the Park.

The more artificial this market, the graver the consequences when market lightening strikes. I know, some say shorters are the bane of free markets. That is not remotely true. But, when I short a calf, it stays short.

Anyway, I just wish I had insider information like those who knew in advance that there would be an announcement about MS and the shorters. I could have bought at $11 and sold at $30. If you think any amount of this silly and poorly written regulation will make a difference, you are not a seasoned observer.

As The New York Times reported today, Davis was president for several years of the Homeownership Alliance, an industry advocacy organization formed mainly by Fannie Mae and Freddie Mac. The Alliance's core mission is to boost the number of mortgages granted.

But take a look at this picture from the alliance's annual report in 2004, unearthed by a reader, showing Davis at a Congressional reception praising minority homeownership (click to enlarge):

"We have an opportunity in the next decade to increase minority homeownership and significantly reduce the minority homeownership gap," Davis is quoted saying here. "The future of the housing market rests heavily on the economic success of minorities. Homeownership is likely to grow faster among minority Americans in the next decade if all the stakeholders in the housing industry work together to make it happen. The Homeownership Alliance is working toward this goal."

It occurs to me that the Dodd plan quacks an awful lot like an incentive stock option. Just as with an ISO, I'd assume that the dilutive effects of the future liability would have to be booked at the time of the issuance of the warrant. That sounds like a fabulous way to crater the stock at exactly the moment that the treasury steps in to buy the bad debt. This is what is sometimes known as an "unintended consequence."

"Barack Obama's running mate says a campaign ad that mocked Republican presidential candidate John McCain as an out-of-touch, out-of-date computer illiterate was "terrible" and would not have been done had he known about it. ...

"I thought that was terrible, by the way," Biden said."

Asked why it was done, he said: "I didn't know we did it and if I had anything to do with it, we'd have never done it."

23 such a loan, the recipient of warrants or any other
24 potential equity in exchange for the loan, and any
25 expected cost to the taxpayer for such exercise.

Believe it or not (I am still shaking my head and trying to figure my next move) I did a text search on the Dodd draft and found that use of the word warrant, after which I revised my sentence which had emphatically declared that the word didn't appear in the bill.

However, that revision didn't end up on the page, so now I am wondering what other revisions got dropped. Troubling.

Anyway, I have made a change to get across my notion that Dodd doesn't use "warrants" in describing this contingent equity make-whole mechanism.

The warrants referred to in this passage could just as well be warrants associated with a troubled asset, depending on the scope of Treasury purchases.

Whoops, the Obamabot Komisariat has had a little talk with Biden. Update:

"[I]n the statement issued by the Obama campaign, Biden said he had never seen the ad and only read press reports of it.

"Having now reviewed the ad, it is even more clear to me that given the disgraceful tenor of Senator McCain's ads and their persistent falsehoods, his campaign is in no position to criticize," Biden said in the statement."

The Colombians found more anti Obama FARC stuff. Maybe they will trade with us now and let us make a few dollars. Pelosi has figured out trade is good because everything else is just giving the money away.

Ben, it's the 36% we have to worry about. The 13% wouldn't buy land anyway, they'd insist the government expropriate it in the name of The People.

Re the Biden statement, can you believe those words were committed to paper? "I didn't see the ad before, but now that I have, I'm going to get back on message and say McCain is worse." I'd be embarrassed to use a sentence that read like his statement in a blog comment.

In case you didn't notice J Street has it's own Astroturf Letter to the Editor generator built in

Here is one printed I found

Middle East progress

I have been reading the latest news coming out of Israel with cautious optimism - the ceasefire with Hamas, an offer to begin talks with Lebanon and the ongoing talks with Syria and the Palestinians. It looks like Israel is heading in the right direction in its quest for security and peace.

I have been struck, however, by the absence of public expressions of support for these recent peace efforts, most notably from the pro- Israel community that is normally such a vocal advocate for Israel and its policies.

As an American who believes that the security of Israel, its neighbors and the United States is enhanced by a peaceful Middle East, I strongly support these initiatives and hope the United States will do more to facilitate their success. I hope that those who consider themselves to be friends of Israel will join me in this strong expression of support.

Good write up by Tom Maguire. It's important for those who understand this crisis to keep adding information to the discussion. I'm finding good information from both conservatives and liberals here, and glad to see both sides agreeing that we need to stop and take a look before we write a blank check to bail out Wall Street millionaires. Too bad the comments section is still uselessly clogged with the redbaiting nonsense of all these tin foil hat oldies who still think this is 1970. Great article, useless discussion section.

Kurtz: "Mr. Ayers is the founder of the "small schools" movement (heavily funded by CAC), in which individual schools built around specific political themes push students to "confront issues of inequity, war, and violence." He believes teacher education programs should serve as "sites of resistance" to an oppressive system. (His teacher-training programs were also CAC funded.) The point, says Mr. Ayers in his "Teaching Toward Freedom," is to "teach against oppression," against America's history of evil and racism, thereby forcing social transformation."

Boy, Ayers sounds just like Jeremiah Wright. Anyone who doesn't realize that Obama wholeheartedly agrees with them is willingly blind.

JOMers will dive into minutia like Ayers, not realizing that there are immediate decisions being made by the current administration of much more import, both to the country and party. And that they will refuse to look at facts curiosly and fairly. Just as they did with defending scrawny Libby and fat Rove, who would have had their asses drummed out of a military school for honor code violation.

But then, you all probably never heard (or believed) the part in leadership class where they say truthfulness is the most important characteristic of a military leader.

I know from personal experience that neither Chris Dodd nor any of his staff have any expertise that remotely qualifies them to address this crisis. The likelihood is that Dodd has been handed something by Bank of America, as he was with the mortgage bill last summer. Watch him in the hearing today and you will see how far in over his head he is.

But then, you all probably never heard (or believed) the part in leadership class where they say truthfulness is the most important characteristic of a military leader.

Oh, please. Project much? Isn't it strange how your "curious" look at each issue just happens to boil down to "Vote Dem" and mimic the DNC propaganda du jour? Wow, what a coincidence. (I mean, what are the odds . . . right?)

Your arguments as far back as I can remember 'em are political, and mostly of the "call to perfection" form (i.e., "I'll vote Republican when they perfectly embody [pick some conservative principle]"); like all fallacies, they're fundamentally dishonest. And 100% Moby. Get a life.

What I wish would happen, and I don't know how to start it, is a demand that Dodd, Barney Frank, Pelosi and Reid step down as a result of this bailout. I have no doubt that more than a few people will glob onto it. I just can't figure out how to get it going.

"But for supposedly very smart people, these traders did some exceedingly stupid things."

Pofarmer,

A) It wasn't their money.
B) They booked a commission and a profit.

There are lots of decent, honest people on Wall Street. The trick is to figure out who they are and for whom they work. I've been watching rather attentively for over thirty years and you'll never hear me say "There's one!".

I ran up the total loan amount of all the ARMs and ALT A loans on the books in August (according to Fed data). It comes to $1.2 trillion with an average LTV of 83%. A 100% default rate with a 40% of appraised value recovery of capital implies a total loss of $650 billion. Actual losses will be a fraction (my bet is less than 1/3) of that number.

Rush was calling for this yesterday, and I think he is exactly right. If they were Republicans, you can bet there would be calls for heads to roll. The folks who led us into this really shouldn't be counted on to lead us out.

Jane start a blog with a petition feature and we'll all do what we can to get the word out about it,

Kurtz really said nothing new to use at the WSJ or NRO today--the records he saw simply confirm what we know--Ayers and Obama were much more closely involved; O wouldn't have been put in charge w/o Ayers say so and their plan was to radicalize the schools w/ things like replacing activism with test scores (not, for their own kids of course--always remember that.)

Who gets to value the contingent liability? Does it go down on the books at 100% of the value of the MSB sold or would a prudent investor demand that it be marked to 125%?

Very good question but I have a more foundational thought.

Why would any institution not beyond desperate allow the trigger of the gun pointed at their head to be fingered by the government and not them.

Think about it, you would have to believe the government is going to be better and more efficient at doing this than you. And remember this removes much incentive for the govt to maximize their recovery since they can just get it back from all but the grossly insolvent with this equity play. So the govt will be motivated to just push these off the cliff as fast as possible.

I think its poison and will prevent the bill from having any takers. I am sure Paulson will tell them that too.

I understand that the language may end up permit but not require equity and let Treasury decide if circumstances warrant an equity stake.

Bernanke's synopsis is good, the missing element is identification of how much Stinky Stuff is already in the Fed's hands after picking up the FMs plus AIG.

GMax,

I hope everyone reads "And remember this removes much incentive for the govt to maximize their recovery since they can just get it back from all but the grossly insolvent with this equity play." a couple of times. It really is a poison pill.

See TCO, not sean, nick, baked, et al; they no longer qualify as trolls, there's a whole other level of taxonomy involved; Urukhai Orcs or because of their high pitched screams, nazguls. We here at JOM,
(I know I'm not officially a member, but a visitor in good standing) realize the media presentation of significant events is not 180 degrees out of phase with reality, but frequently 540 degrees. I know that shouldn't be possible, that's a whole other
plane or reality but it is. The witchhunt against Libby, for something Armitage had done despite the fact that he essentially agreed wit Novak and Plame. His cooperation with Powell, who turns out not to be a simple career bureaucrat, but the promoter of consistently counterproductive practices
and dubious business practices; ie his longstanding ties to the Saudi dynasty, his subsequent ventures with Caspian oil interests which dictate an acquiescence with Iranian and even Russian practices. The
non stop efforts to purge Goss's reformers, brought to light most recently by Ishmael Jones, new memoir. The Gitmo detainee's get
out of jail free card, promoted by Kuwaiti and Emirati interests to gullible journalists. The steamroll to abandon US forces in Iraq and now Afghanistan; even as contrary evidence of their success has happened.

Now the focus shifts to the nature of the subprime hurricane, which threatens to do to us; at the least what the 1980s land bubble inflicted on Japan for a span of years. The worst is a return to Mr. Mellon's liquidation of labor, capital, et al; the Great Depression We see Senator McCain, members of the administration, and even old curmudgeon Greenspan, when he wasn't dictating his epitaph; sorry the Edge of Turbulence, saw the Iceberg, but many refused to steer away, among them Dodd and Frank. I say in decreasing importance, because Greenspan's 18 consecutive interest hikes; like his twelve previous prior to the tech crash, would inevitably tip the balance. So the Conneticut Yankee and his Faneuil Square squire, Who have been wrong so many times before, on Central America, crime policies, et, have done it again so using them as authorities seems like promoting Mr.Ismay, the head of the White Star Lines to the head of the British Admiralty.

Doing the bailouts and then trying to regulate markets from taking risks "so it doesn't happen again" is asinine.

Let those who took a risk and lost, take their medicine. You shouldn't cushion foolishness. You can't prevent it in the future. People will always have the ability to leverage themselves in risky transactions. Let the counterparties take that risk. Not the Treasury.

Couldn't McCain easily make hay right now by demanding the resignations of Dodd and Frank? Between the Fannie/Freddie campaign donations, the sweetheart mortgage, the past opposition to regulatory reform, Dodd in particular is a sitting duck on this. Why not pull the trigger?

Can't keep up with the comments so sorry if this point was made elsewhere.
Seems to me Krugman and by extension Dodd are missing the point of what Paulson is trying to do. Maybe some of the folks here who know more about this than me can correct me where necessary.
All this talk of how buying the bad debt does not fix their balance sheets is beside the point. He isn't trying to balance the books of every bank in America nor make every insolvent or illiquid bank solvent or illiquid again.

The model of the 'bad bank' is to unfreeze the system. An unfrozen system can absorb some bank failures; a frozen one can't.

Right now no one trusts anyone else and they don't even trust themselves. The bad debt is like unexploded ordinanace on their books. No one can tell who is about to blow up in a matter of days and so they are reluctant to loan to each other for any purpose. And They are afraid to loan to businesses and consumers for the same reason and because it increases their need for capital which they are having a hard time raising as it is.
By taking the bad debt off their books it allows trust to reenter the market as all the unexploded bombs are now safely at the armory and have been replaced by cash or other transparent obligations. Perhaps that doesn't instantly cure their balance sheet but it does give lenders and borrowers confidence that assets being loaned against will not drop to zero so the market thaws and money begins to move again.
In addition it frees up those banks on the edge, mking it easier for them to recapitalize because they aren't threatened with continued downgrades. It also gives them the option, if push comes to shove, to either buy a smaller, more solvent bank to fix their balance sheet or be acquired at something other than the bankruptcy court price. Right now a bank on the edge has two choices liquidate in bankruptcy or through the fed.
Trust is what is missing and can only be restored by the elimination of the bad debt.
It cannot be eliminated on a case by case basis as they were doing. At this point I'm not sure there is any other way of doing it, short of an economic tsunami, as bad and uncertain as the Paulson plan is.

If Rick is right on his footings of the debt, then this will certainly pile up all the putrid stuff in one pile.

Some institutions will shrink to show a higher capital ratio, others will search out new lines of business and new credits to lend.
Both have a salutary effect. One increases confidence, one adds liquidity. Both are missing.

Now I understand that on top the the previous sale by ML at 22 cents on face value, that there is a very recent sale by Sovereign Bank at 35 cents on the dollar. I have not yet confirmed that with my own eyeballs but the CNBC cats were squawking about it yesterday afternoon.

That tends to reassure me that if vultures who will expect 20 to 30% returns on equity see value at 1/3 of face, that Treasury can get back to shore at 50 or 60 cents per face.

I have a hard time believe any mezzanine pieces are on regulated institution books at much above 50 cents, as both the examiners and the auditors have been pounding on these numbers for some time.

I therefore think the Treasury is not ultimately going to put out much if any of the taxpayers money here once the big pile is liquidated by collections, foreclosure and resale or resale to folks who are not vultures and will accept less than vulture returns.

The alternative is pretty clear, read both Bernanke and Paulson, if you want to be selling apples on the street corner due everything you can to sabotage this plan, there is not another one waiting in the wings.

TCO, since you kept the snot nosed profanity and insults out of this post let me respond.

I agree with you in principal, but my concern is that this freeze up is so systemic and global that there is a very serious risk of a great many people who took no risk being crushed under the repurcussions of letting the market takes its course. There are hundreds of millions of people worldwide who have just barely crawled out of eternal poverty in the last decade and may very well be tossed back into it for God knows how long if this is as contagious as it seems it could be. If it had been allowed to run its course intitially perhaps the effects could have been contained but that seems unlikely now.

Doing the bailouts and then trying to regulate markets from taking risks "so it doesn't happen again" is asinine

Agreed. If this is not followed by the complete privatization of Fannie and Freddie and a return by the fed to a sound currency rather than the Greenspanian manipulation of the economy, both of which are the core of the problem nothing will be solved.

I agree fully. I view Kurtz's article as "CAC for Beginners," and that he is using this one to raise awareness and to provide a basis for subsequent ones.

Diamond's follow-up is worthwhile too -- he goes to his expected theme (of authoritarianism), and fills out the local scene well. He asks the question, why did Annenberg fund the effort if it was so leftist, and his answer is that it was intended to fight the Chicago bureaucracy and the teachers' unions. That to me is only a slightly better explanation.

My guess is that both are present, and Annenberg funded this approach as one of a basket of approaches to see what worked.

Does anyone know how the Annenberg grants made to other locations worked in practice?